Has gold as a safe haven turned into a bubble? More importantly, if that bubble pops, would the Indian financial system be at risk? These weighty questions are addressed by RBI staffers, Rabi N. Mishra and G. Jagan Mohan, in their recent working paper “Gold prices and Financial Stability in India”

(http://rbi.org.in/scripts/PublicationsView.aspx?id=14015).

The researchers used econometrics to analyse gold's relationships with other variables, studying data spanning two decades. At the end of it, they say there is no conclusive evidence that gold prices are in bubble territory. But they do point out that gold prices have been behaving quite strangely since 2003.

Overall, however, they reach the comforting conclusion that even if gold prices were to fall, this wouldn't pose a serious risk to the Indian financial system.

First, the authors use statistical analysis to prove that it is international gold prices and the (rupee-dollar) exchange rate that exert maximum influence on Indian bullion prices.

This is explained by two factors. India imports much of its gold requirements and the de-regulation of gold imports has made sure that much of it today flows in through official channels.

BREAK FROM THE PAST

Now, if Indian gold prices merely move in step with global prices, what are the factors that sway global gold prices? Well, these have kept changing.

Analysing gold's relationship with other financial market variables, the authors conclude that prior to 2003, stock prices, global inflation levels and the dollar were the biggest factors affecting international gold price movements.

At that time, gold proved a good long-term inflation hedge and usually moved in the opposite direction to the stock markets.

But post-2003, these traditional relationships have been breaking down. In this period, global inflation rates alone have influenced gold prices.

For shorter periods, even inflation isn't a factor; it is gyrations in the US dollar that are impacting gold prices more than any other variable.

From this, the authors surmise that “perhaps the unabated rise in international gold prices since 2003… are a result of panic buying”.

BUBBLE?

So if gold prices are indeed behaving unusually, are they in the bubble territory? There are no clear answers.

After all, the very definition of a bubble requires one to prove that an asset price has shot up far beyond its intrinsic worth.

Now gold, unlike stocks or bonds, does not yield any regular cash flows to people who own it, thus defying conventional measures of intrinsic worth.

The authors sidestep this problem by looking at gold's value in relation to other assets. They find that, over the last five years, gold has become more expensive relative to a range of other assets — the US stock market, global commodities index, crude oil or gold mining companies.

A unit of all these assets today will buy less gold than it did a few years ago.

SO WHAT?

Okay, assuming that the recent rise in gold prices isn't easily explained, what will be the impact on India's financial system if gold prices tumble?

Tracing the history of asset bubbles, the paper observes that the popping of bubbles impacts the economy as a whole, only under certain conditions. One, if the asset is held by key cogs in the financial system — like banks. Two, if price rise is fuelled by increase in money supply, credit and leverage.

On these counts, the authors conclude that India does not face much systemic risk from gold price correction. They substantiate this claim by devising a measure called Financial Market Stability Indicator.

This is explained thus. Most of the country's hoard of gold is lying, not with the central bank or even the banking system, but with the ordinary retail households. If gold prices correct, these households may actually re-allocate money to more productive assets such as the stock market or bank deposits.

Good as it is, the paper leaves some questions unanswered. Thus, why has the study relied so much on global statistics on gold? Surely, it would be more authentic if it used Indian data on gold ownership and buying patterns, as also investment demand, to substantiate its points on systemic risk.

And what about the gold loan industry which has been growing by leaps and bounds in recent years?

Yes, Indian banks may not directly hold much gold today. But they are lining up significant forays into the highly profitable gold lending business.

In doing this, they are taking a leaf out of the books of large NBFCs, which have popularised organised gold lending.

As more Indian households opt to monetise their gold holdings through these means, will falling gold prices pose a systemic risk?